What next for US-Europe trade policy?

The economies of Europe and the United States are inextricably linked and in an ideal world, a number of factors motivate a trade deal such as the Transatlantic Trade and Investment Partnership. This column, taken from a recent VoxEU eBook, argues, however, that given the Brexit referendum in the UK and the election of Donald Trump as US president, as well as a number of other pre-existing complications, achieving such agreements will be highly contentious.

The economies of Europe and the United States are inextricably linked, they are the world’s two largest economies, the EU is the US’s largest trade partner (excluding the NAFTA trading bloc), while the United States is the EU’s largest external trade partner in both goods and services.1 The US Department of Commerce estimates that US exports to the EU support around 2.6 million American jobs, while almost 200,000 European companies sell goods and services to the United States.2 Furthermore, the two economies make up around 60% of the world’s inward stock of foreign direct investment (FDI), and over 80% of the world’s outward stock of FDI, a large portion of which is due to flows between the two (European Parliament 2016).

In an ideal world, a number of factors motivate a trade deal such as the Transatlantic Trade and Investment Partnership (TTIP). However, given the June 23, 2016 Brexit referendum in the UK and the November 2016 US election results, as well as a number of other pre-existing complications, achieving such agreements (now both EU-US and UK-US) will be highly contentious.

Tricky but achievable – tariff cuts

The first obvious point of call in a trade deal is tariffs. Most Favourable Nation (MFN) import tariffs for both the EU and the United States are, on average, low, and there is a good chance the UK will maintain the tariffs it currently operates as an EU member, after Brexit is complete (HM Government 2016). The weighted mean tariff for all products, for both the EU and US is 1.6%, and thus, at face value, it appears changes to tariffs are relatively unimportant.

However, as often can be the case, averages have a habit of hiding some sector specific high tariffs. For example, the EU tariff on motor vehicles is 10%, while the US counterpart is 2.5%, similarly EU tariffs on fish can be as high as 25% while US tariffs on fabrics and apparel are at similar levels. Leaked TTIP documents showed that, as of negotiations at the end of 2015, tariffs would have been reduced by up to 97.5% (von Daniels and Orosz 2016). It’s no surprise that the trade deal received backing from business groups such as the German Association of the Automotive Industry, who estimate that tariffs cost the industry approximately €1 billion per year (IMCO 2015).

Trickier but reasonable – non-tariff barriers

While tariffs are the starting point of trade agreements, the most important motivating factor of modern trade deals is the removal of non-tariff barriers (NTBs), such as regulatory differences, through harmonisation of standards and customs procedures and regulatory cooperation across borders. Examples of divergent regulation include differences in safety standards, environmental and emissions regulations, eligibility of foreign firms for government procurement, and competition policy, while NTBs in customs procedures generally relate to things such as port inspections and rules of origin.

The regulatory divergence between the EU and United States is non-trivial and far ranging. One significant difference is the statutory application of the precautionary principle in EU law, which has no similar equivalent in the US. The precautionary principle, which results in the burden of proof of safety falling on those wishing to take an action in the absence of scientific consensus, has implications for regulations related to environmental, pharmaceutical, agricultural and product standards.

As highlighted by Fontagné et al. (2013), there are some simple solutions to closing these differences, such as an extension of mutual recognition of technical standards and expanded labelling for food products. However, when regulation exists due to a clear difference in preferences, convergence is generally problematic.

A review of studies by Berden and Francois (2015) found the trade cost equivalent (TCE) (i.e., the synthetic ad-valorem tariff equivalent) on all goods between the EU and US range between 12.9% to 13.7%, with some sectors such as agricultural products, beverages and tobacco, pharmaceuticals and processed foods being considerably higher. Importantly, for modern economies such as the US and the UK, where the majority of employment is now in the service sector, they find estimates of TCEs for the service sector ranging between 8.5% and 47.3%, with specific sectors such as business services and financial services facing on average around 30% TCE. All studies reviewed conclude that NTBs matter, and more so than tariffs. A report by ECORYS commissioned by the European Commission (Berden et al. 2009) suggested that between 25-50% of these NTBs could be removed, and, in the more optimistic scenario, exports would increase by 6.1% for the US and 2.1% for the EU. According to a study from the CEPR (Francois et al. 2013), a FTA that removed 25% of NTBs would boost trade by 75% more than a FTA that removed only 10% of NTBs.

These estimates apply to the EU, inclusive of the UK. In a post-Brexit world, matters get somewhat more complicated. The UK government has made it abundantly clear that they wish to exit the EU Customs Union so they can pursue their own trade deals with the likes of the United States (HM Government 2016). This seems like a logical way of making up for the losses in trade and investment that would arise when the UK breaks away from its largest trade and investment partner – the EU. Estimates suggest that wiping out tariffs between the UK and the US would make up for just a tiny share of the losses from Brexit. This is because the US is a more distant market for the UK so there is naturally less trade between them. With tariffs already low, expansion in UK-US trade would need a lot more regulatory harmonisation (Dhingra et al. 2017). Given that the UK currently operates the same regulatory framework as the rest of the EU, the same regulatory divergence problems arise in the UK-US relationship. And, without the clout of the EU, UK trade negotiators would have much less bargaining power in getting a good deal from the US, for obvious reasons (both the US’s GDP and population are approximately five times larger than the UK’s).

The implementation of regulatory cooperation between the US and the UK would also face practical difficulties. Outside of the EU, the UK will need to replicate around 34 different regulatory agencies for various sectors (Fraser 2017), which are currently operated through the EU. This would require a large increase in nuanced expertise and civil servants, and likely be infeasible given the current two-year time frame for Brexit. The UK could stay under the remit of some EU regulatory agencies, and this may well be a necessary part of a new trade agreement between the UK and EU. But this would mean the UK needs to resolve its new trading arrangements with the EU before attempting to lower NTBs with the United States. Furthermore, constraints on this would still apply in sectors that continue to be overseen by EU regulatory agencies, unless an EU-US deal is struck in tandem. Any potential US-UK trade deal is therefore likely to be delayed for at least a couple of years, despite the enthusiasm of their current governments.

The achievable and the reasonable – trade and income impacts

The big gains from a transatlantic deal will come from lower tariffs and NTBs. Estimates from the CEPII (Fontagné et al. 2013) suggest that the impacts of a TTIP-like deal on incomes would be non-trivial. In particular, in the scenario of a complete phase-out of tariffs combined with a 25% decrease in NTBs, the EU would see a $98bn positive impact to GDP while the US would experience a $64bn gain. Estimates from ECORYS (European Commission 2016), suggest similar impacts to GDP of around 0.3% for both areas, while also predicting an increase of 0.5% for wages of both high and low- skilled workers by 2030. In addition, on the labour front, while most models aren’t able to predict employment effects due to assumptions of full employment, some estimates of labour displacement for a 2027 benchmark range between 0.2%, in a less ambitious deal, to 0.65%, in a more ambitious deal (Francois et al. 2013).

These estimates are not without contention however. Civil society organisations have highlighted the failings of estimates of previous trade agreements such as NAFTA (e.g., Hilary 2015). One of the most widely cited studies (Hufbauer and Schott 1992) predicted a large 130,000 employment gain for the US, while another predicted an approximate 0.3% welfare gain coupled with a 0.2% increase in real wages for the US, and a 0.7% welfare gain for Canada (Brown et al. 1992).

When compared with ex post studies, such figures appear highly inaccurate. Recent work finds that the US’s welfare increased by just 0.08%, while Canada’s declined by 0.06% (Caliendo and Parro 2014). Importantly, labour market evidence points to dramatically lower wage growth for blue collar workers in the US, and knock on effects to service workers in their localities as a result of NAFTA (Hakobyan and McLaren 2016).

Domestic policies have already failed to do much for those who have been displaced by increased globalisation and technological change. Amid this distrust of globalisation, additional job displacements and churning would make a transatlantic deal even more unwelcome. But by far the greatest discontent from a future transatlantic deal will be based on how the EU and the US deal with the rights of foreign investors in the agreement.

Avoiding the death knell: Investor to state disputes

Foreign investment is the ‘real driver’ (Gambini et al. 2015) of the transatlantic economic relationship. The EU and the US account for about 40% (Eurostat 2016b) of each other’s inward FDI stock. Any investment-related clause in the trade deal between the EU, the US and the UK therefore has far-reaching implications for firms, workers and consumers.

The TTIP’s proposed mechanism for settling disputes between foreign firms and host governments is its most controversial component. The head of trade policy of the UK’s Labour Party described it as a ‘threat to democracy’ (Hilary 2015) and the greatest threat posed by TTIP. Initial texts contained an Investment State Dispute Settlement (ISDS) mechanism (European Commission 2015), which gives foreign firms the right to bring claims against host country governments if they have not been given ‘fair and equitable treatment’.

According to economic theory, investor protections, such as ISDS, enable firms to recoup damages from host country governments, if they engage in policies that reduce the returns to sunk investments made by foreign firms (Blanchard 2015). Host country governments might directly expropriate the assets of foreign firms or put in place domestic policies that harm the profitability of foreign investments.

The WTO disciplines the use of trade-related domestic policies, such as local content requirements or foreign exchange rationing, that favour domestic firms over foreign investors. But it focuses on investment measures that have the potential to restrict or distort trade, and does not cover behind-the-border policies that are not trade-related (Blanchard 2014). TTIP seeks to fill this gap in policy through its proposed ISDS, which would allow foreign investors to dispute any alleged breach of commitments of the host country.

This seems like a sensible approach to attract foreign investments which might otherwise be too risky to undertake in the host country due to its changing political, legal or social circumstances. But one concern is that, under the ISDS, disputes brought by foreign investors are resolved by a tribunal that is outside the scrutiny of the host country’s legal system. Another is that the set of behind-the border policies that affect foreign investors is so broad that the threat of disputes can severely limit the policy space available to governments. For instance, Calgary-based company Lone Pine Resources, which is registered in Delaware, has claimed damages for the potential losses from the Quebec government’s moratorium on fracking. Although a decision is pending, this case has become the poster child for the chilling effects of ISDS on government’s ability to regulate (Beltrame 2013). Many therefore view ISDS as a way of giving foreign firms excessive powers – typically not available to domestic firms – to challenge policies decided by national and local governments, especially in socially sensitive areas like environment, natural resources and public health.

These concerns are also reflected in a recent case against Germany brought by a Swedish firm under the Energy Charter Treaty. After the Fukushima nuclear accident in March 2011, Germany announced it would withdraw the operating licences of eight nuclear power plants, which included two plants of the Swedish company Vattenfall (World Nuclear News 2014).

Vattenfall sued Germany at the International Centre for Settlement of Investment Disputes in Washington DC over the closure of its plants and demanded USD 6 billion as compensation. Meanwhile, the German Constitutional Court ruled that the State has the broad regulatory powers to take such a decision but it must compensate the plants for any unjustified expropriation arising from its decision (Kluwer 2016).

This prompted the question – why must Vattenfall sue Germany through an international tribunal when the domestic legal system is capable of making fair decisions? Civil society groups argue that developed economies with a strong legal system do not need extra-judicial bodies to resolve foreign investment disputes (Bernasconi-Osterwalder and Brauch 2014). As public money is involved, damages should not be decided by arbitrators who are in no way accountable to the public, and whose decisions cannot be reviewed for legal or factual correctness. Prominent cases like these are likely to harden public opinion against TTIP. Already, a YouGov survey from 2016 shows that support for TTIP has fallen dramatically – just 17% of Germans and 18% of Americans believe TTIP is a ‘good thing’, compared to over 50% two years before (Bluth 2016).

Treading the populist path

Citizen groups and academics have expressed grave concerns in public consultations3 about the ISDS, and Parenti (2017) suggests that opposition from member countries like Belgium, France and Germany has prompted the EU to move away from the language of the ISDS. But the EU and the US remain steadfast in their decision to include an investor to state dispute settlement provision in a future deal. This will likely take its cue from the pending EU-Canada Comprehensive Economic and Trade Agreement (CETA).

CETA provides for an investment court system which addresses some of the concerns with the ISDS such as appointing public judges, having an appeal system and tightening the language on what constitutes fair and equitable treatment for foreign investors.

If the investment court system is ratified under CETA, the key source of contention in a future EU-US deal would be largely bypassed. According to the consumer advocacy group, Public Citizen, which was founded by Ralph Nader, over 80% of US-owned subsidiaries in the EU belong to parent US firms that also have operations in Canada. These US firms would already have access to the investment court system through CETA, and would not have to wait for TTIP’s investment chapter. The EU expects the investment court system to become the model for its investor dispute settlement process in future trade deals (Biel and Wheeler 2016). But questions over the legitimacy of the investment court system persist (Dearden 2016), and its legality will be decided by the end of 2017 (Dentons 2017).

On the US side, the poll findings of Democracy Corps, in the context of the US Trans- Pacific Partnership, are instructive in gauging how a future debate over investment provisions might play out. A majority of the Americans polled were unfamiliar with the agreement or neutral towards it, but a vast majority – 70% – became more opposed to the agreement after hearing the anti-ISDS statements that were read out to them. If the debate over TTIP centres on investment protections, the public might perceive their governments to be favouring big multinationals, and we might yet see another backlash against future deals between the US and Europe.

This would mean that the potential efficiency gains from streamlining duplicate regulations and tariff peaks would be lost in a zeal to give special rights to foreign investors. There is little empirical evidence that these rights increase foreign investments, so an economically sound alternative is the US-Australia trade agreement, which settles investor to state disputes within the domestic court system. This precedent was motivated by Australia pointing out that developed economies with advanced domestic legal systems do not need ISDS-type clauses because their domestic court systems have an established record of upholding the rule of law (Faunce 2015). The US, UK and EU fit this bill. It’s not surprising then that the independent study commissioned by the UK’s Business, Innovation and Skills department concluded that ISDS-type clauses would provide little economic benefit and expose the State to meaningful political costs (Poulsen et al. 2013).

In the current era of strong anti-globalisation sentiments, even small political costs could heighten economic nationalism. Recent political developments – Trump, Brexit and the anti-EU rhetoric – reflect a desire to rebalance economic power and reclaim sovereignty (Colantone and Stanig 2017). After years of uneven economic growth and austerity cuts, people have used their votes to express anger at the political establishment and their failed economic policies (Dhingra 2016). Proposing trade deals that give special rights to foreign investors, based in countries less aligned to the existing preferences of citizens, would alienate people further, and likely derail future transatlantic partnerships.

IMCO (2015), “The Transatlantic Trade and investment Partnership (TTIP): Challenges and Opportunities for the Internal Market and Consumer Protection in the Area of Motor Vehicles”, Directorate General For Internal Policies, European Parliament.